What is a Roth and Traditional IRA?

What is an IRA and how to tell the difference between Traditional and Roth?

If your an avid news junkie you probably stumbled across the story of Mitt "Baller" Romney's Individual Retirement account (IRA) being worth millions of dollars. Many people's initial reaction to the article was where the hell do I sign up for one of those retirement accounts so I can be sipping a Roy Rogers at Club Med instead of greeting obese Americans at Wal-mart when I'm 70?

First lets define what an IRA is. Simply put an IRA is an account with huge tax breaks were you can store money and other assets for when you retire. However it is not an investment! It's your responsibility to invest your money once it's deposited into the account. The IRA is simply an account that HOLDS investments such as stocks within it. Think of an IRA exactly as a normal brokerage account were you keep stocks, bonds, mutual funds, and other assets but unlike a normal account it is sheltered from taxes.

So to make what I said more digestible I'll use this example. If I deposit $500.00 into my IRA and leave it there for 20 years it will not gain any interest or do anything, just like a brokerage account at say E-Trade. However once that $500.00 is in my account I could than invest it in bonds, Apple, Microsoft or 1,000's of other securities instead of letting the cash sit there non invested and gaining zilch.

Now I hope your not going to drop off here because there is much more to be learned about the IRA. If your confused now I guarantee you'll be an expert by the time were done.

There are two main types of IRA's. The Traditional IRA and the Roth IRA. (Yes I realize there are more types, but were not going to cover them) They both have their differences and unless you want to sound like a moron in front of your friends I suggest you read on.

The Traditional

Historically the most common IRA is you guessed it, the Traditional. The only requirements to opening one of these suckers is that you're required to have earned income and be below 70 ½ years of age.

This IRA is tax-deferred. So what in the world does that mean? Basically it means when you deposit your hard earned money into the account you don't pay any taxes on it and it gets to grow tax free. However when you take it out years later during retirement you have to pay old Uncle Sam his taxes. The good thing is hopefully when retired you're in a lower income tax bracket (no longer working) than you were in the peak of your career.

Let's say a gentleman named Danny rakes in $50,000 a year at his job as a Mechanical Engineer at Lockheed Martin. That same year Danny sets up a traditional IRA and deposits $2,000 in his account. Danny is legally allowed to deposit up to $5,000 or if he's over the age of 50 up to $6,000 as of 2012, but in our example he just deposits $2,000 for the year. That year he would only pay income tax of $48,000 instead of $50,000.

At the age of 59 ½ Danny is finally allowed to take out his IRA money penalty free. Lets say though at the age of 52 his daughter picks up a nasty heroin addiction and Danny desperately needs to withdrawal from his IRA early to pay for her pricey rehab. Danny would be hit with a 10% IRS penalty for distributing the money out early plus he would have to pay income tax. If he was in the 35% income tax bracket his tax would be 45%. Ouch! It can hurt to withdrawal before 59 ½ unless it's for one of the eight approved reasons such as a new home purchase or higher education. You'll have to check out the IRS website if you want to learn more about those.

Something to remember though about the Traditional IRA. At 70 ½ you are absolutely required to begin taking a yearly distribution based on your life expectancy. This is because your greedy uncle Samuel is getting angry that he hasn't still got his cut so now he's forcing you to withdrawal the money and pay taxes on it. If you refuse to take it out or forget you'll face some substantially large penalties on that years amount you were required to withdrawal.

I'm guessing a lot of you who aren't math or finance whizzes (like myself) are still wondering why would I open up an IRA account instead of just a normal brokerage account.

Well here's an example of if your saving for retirement an IRA is more beneficial. Say your 22 years old and earning $35,000 a year and are in the 25% tax bracket. If you contribute $5,000 that year to your IRA you only pay taxes on $30,000 thus saving you $1,000 in taxes you would have to pay. Plus every year your going to be getting dividends, interest and you may buy and sell stocks quite frequently you had gains on. All of this is going to grow tax free and compound over the years. Even if your in a high tax bracket when you withdrawal.

The Roth

The Roth IRA is similar to the Traditional but it's becoming extremely popular and many people are beginning to like it more than the Traditional. The Roth IRA is the other main type of IRA but unlike the Traditional you contribute money you already were taxed on. That means no writing off your $5,000 dollar contributions and paying less taxes for that year. However when you withdrawal the money you pay NO taxes, can make contribution past 70 ½, and aren't ever forced to take your money out. Sounds pretty sweet so read on.

If your super rich than unfortunately you won't be able to set up a Roth IRA. The Roth IRA has strict eligibility requirements but I'm going to guess a large percentage of you reading this do qualify. For 2012 I believe you had to be making $125,000 and under if your single and wanted to set up a Roth. Obviously it's a little higher for married couples. This number is also based on Modified Adjusted Gross Income. Check the IRS website to see if you qualify.

The mean reason why the Roth is so awesome is because it grows tax free just like the Traditional but you never have to worry about being taxed when you withdrawal the money and your not forced to take out money every year beginning at 70 ½.

One important thing to remember is you can still face harsh penalties for taking out money before 59 ½ even though you already payed taxes on it. You'll be usually taxed only on any earnings you withdrawal since you already payed taxes on the contributions. This means if you deposited $2,000 you can withdrawal $2,000 before the age of 59 ½.

Let's say at the age of 40 you decide to take an early distribution for the entire amount of your IRA. Yikes. 2 years ago you made a contribution for $3,000 and that contribution has grown now to $4,500. Since the distribution is non-qualified your going to be taxed heavily on that $1,500. You'll have to be whatever your income tax bracket is plus the 10% penalty. A decent sized junk of that $1,500 is gone. Remember though that there are certain qualified ways you can take out an early withdrawal and not be penalized such as a disability or medical emergency. In addition to being 59 ½ you also must have the money in the account for at least five years after you opened and funded it.

All these penalties may sound harsh but if you use the IRA for what's intended for (retirement) it can be a kick ass way to not just wither away in your basement at 67 and instead travel the world, eat, live comfortably, and leave money for your family.

So go to your most convenient bank or broker and set one of these up today and please start saving. Though it's better to start early, late is better than never!

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